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Behavioral Economics, Neurofinance and Why You Are Not Wired to Make Intelligent Financial Decisions
The cognitive shortcomings of Investors
Presentation by Barry Ritholtz CFA Toronto Annual Forecast Dinner October 1, 2013
Your brain weighs 3 pounds, and is 100,000 years old. It is a dynamic, opportunistic, self-organizing system of systems. MRIs have revealed to Neurologists what our brains looks like when making decisions . We can observe it 1) in real time; 2) under actual conditions, and 3) in reaction to financial risk/reward stimuli. Once we begin trading stocks, however, our brains begin to undergo subtle physical change that we can actually see in the MRIs of Traders . . .
Neuro-Finance
Physiological internal activity not discernible to the naked eye alone 7. Anticipation vs. Rewards 8. Selective Perception & Retention 9. A Species of Dopamine Addicts 10. Endowment Effect of Ownership 11. The Narrative Fallacy 12. Cognitive Errors Impact Processes
A brief intro to
Behavioral Economics
Herding
2.
3.
Equity Analysts Too Bullish and Bearish at the Exact Wrong Times
-McKinsey, June 2nd, 2010
4.
None of the S&P 1500 have a Wall St. Consensus Sell on them
-Robert Powell, Editor, Retirement Weekly, August 2011
It is better for one's reputation to fail conventionally than to succeed unconventionally. -John Maynard Kyenes
Analysts have been persistently overoptimistic for the past 25 years, with [earnings] estimates ranging from 10 to 12 percent a year, compared with actual earnings growth of 6 percent On average, analysts forecasts have been almost 100 percent too high -McKinsey study
Optimism Bias
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Optimism Bias: The unfortunate tendency to expect the best possible outcome regardless of the evidence before you.
Dunning Kruger Effect: DK is a cognitive bias in which unskilled people make poor decisions and reach erroneous conclusions, but their incompetence denies them the metacognitive ability to recognize these mistakes. Metacognition: The less competent you are at a task, the more likely you are to over-estimate your ability to accomplish it well. Competence actually weakens self-confidence. This has devastating consequences in the investment world.
1. Emotions change the way we perceive events (e.g., Sports) 2. Buy to the sound of cannons, sell to the sound of trumpets. -Attributed to British banker Nathan Mayer Rothschild, during the Napoleonic wars Buy the Rumor, Sell the News 3. Anticipation vs. Rewards: Is it in the Stock or in the Brain?
What does this mean for investors? We have an Optimism bias (helps our survival). Our brains are better at processing good news about the future than bad. Anticipation of financial reward > than actual benefits (Buy Rumor, Sell News) Gamblers, Alcoholics, Sex Addicts, Junkies, OA, Hyper-Traders = Dopamine High.
A brief intro to
Neuro Finance
If u cn rd ths . . .
This animation . . .
. . . is not an animation
Image by German photographer Thomas Hoepker, published in 2006 David Friends book, Watching the World Change
Sentiment Cycle
Source: Ritholtz.com
We have met the enemy, and he is us. -Walt Kelly, Pogo, 1971
1. High Fees Are A Drag on Returns 2. Dont Reach for Yield 3. Never Confuse Past Performance with Future Potential 4. Asset Allocation Matters More than Stock Picking 5. Passive vs. Active Management 6. The Future is Inherently Uncertain 7. Understand the Long Cycle 8. Be aware of your Cognitive Errors 9. Allow Compounding to work for you 10. You (and your Behavior) Are Your Own Worst Enemy
Barry L. Ritholtz
Chief Investment Officer Ritholtz Wealth Management 90 Park Avenue, 18th floor New York, NY 10016 516-455-9122 Barry@RitholtzWealth.com